The Alleged Asymmetry in Maintaining a Fixed Exchange Rate

Abstract

To discuss the consequences of a given exchange rate regime, textbooks in international monetary economics or international finance generally simplify the different regimes down to two cases: a flexible vs. a fixed exchange rate regime, whereby for ease of interpretation, the world is often summarized by two countries and hence two currencies. Under a floating exchange rate regime, market participants active on the exchange rate market determine the value of the nominal exchange rate by acting on fundamental information and whatever else is driving their expectations. In the second case, at least one central bank has promised to trade the foreign currency for a specific amount of the home currency. As long as the economic fundamentals are in line with the declared exchange rate, making the central bank’s commitment credible, supply and demand on the exchange rate market are likely to meet without the need for the central bank intervention. However, when supply does not meet demand, the central bank will have to act on its promise. To alleviate upward pressure on the home currency, it will buy foreign reserves, while depreciation pressure will be countered by selling foreign reserves.